INTM551050 - Hybrids: financial instruments (Chapter 3): overview: quasi-payments - derivatives

Derivatives

The position as regards exchange losses on derivatives and fair value losses on derivatives more generally is different. This is because the fair value of a derivative will respond to changes in value of its underlying subject matter, irrespective of the functional currency of a company: a comparison of the value of this subject matter with some fixed price or other variable will always be a feature of the terms of the derivative. In an option or forward the comparison is with a fixed amount. Other simple derivatives will have two legs each exposed to a different variable.

A very simple example of a derivative is a currency swap. A company would have a “short” euro position on a currency swap if it agreed to pay €100m in three years’ time, paying a 6-month euro LIBOR on €100m every 6 months, in return for receiving £90m in three years’ time and receiving a 6-month sterling LIBOR on £90m every 6 months (£90m is assumed to be the spot rate equivalent of €100m on entry into the swap). This is similar to making a three-year loan of £90m and borrowing €100m from the same counterparty, but the credit risks are offset. The swap is primarily exposed to two variables, the value of €100m and the value of £90m.

If the euro strengthens against sterling the company will make an exchange loss, as the in-substance €100m loan it effectively exchanged for the £90m loan will be a relatively heavier burden. This is not dependent on the functional currency of the company because the sterling leg is built into the swap and the movement in value of the euro relative to sterling inevitably changes the fair value of the swap. The change in value results from the comparison of one leg of the swap with another, rather than, say, between the single leg of a euro-denominated debt security and a company’s sterling functional currency. Regardless of the functional currency the company will have a liability that is now considered more expensive, effectively exchanging euros for sterling.

Derivatives including currency swaps will normally be accounted for on a fair value basis whether under IFRS (IFRS 10) or FRS 102 (section 12). For the swap considered here, the fair value movement is almost entirely driven by the euro/ sterling exchange rate. (There will be some ‘noise’ because of the effect of changes in interest rates between the 6-monthly resets of the LIBOR rates.). If a UK company with a short euro position on the swap made a fair value loss on the derivative, this would give rise to a ‘relevant deduction’ within s259BB(2)(a). If the assumptions in s259BB(4) are made as regards the swap counterparty, it would be expected to have a corresponding gain irrespective of its functional currency, which would be subject to corporation tax and so treated as ordinary income. Accordingly, the condition in s259BB(2)(b) would be satisfied.

Thus, the UK company’s fair value loss on the derivative gives rise to a quasi-payment. This will generally be the case for fair value losses on derivatives.

Whether a counteraction arises depends on whether the other conditions in s259CA are satisfied.